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Interview: Chris Abraham On Mixing Value Investing And Options

By Rupert Hargreaves Rupert Hargreaves: You run a unique, value-based options strategy, which is designed to take advantage of price inefficiencies in the market. Could you give our readers a brief description of the strategy and why you decided to use it? Chris Abraham: It is basically a concentrated, long-term, all-cap value-oriented strategy primarily focused on the equities and options of high-quality companies. Ideally, I look for companies with a competitive advantage that trade at a margin of safety. I typically have around 10 to 20 equity holdings in my portfolio, preferably closer to 10. Regarding option positions, the way I look at the strategy is kind of like running an insurance book along with existing equity holdings – similar to Buffett’s concept at Berkshire (NYSE: BRK.A ) (NYSE: BRK.B ). Buffett has been able to create permanent capital for investing by using Berkshire’s insurance subsidiaries’ float. And that’s the kind of business model that I’ve tried to create, except with options. RH: So you write options to generate income and grow the float? CA: Exactly. The vast majority of options trading is on ETFs, and most of that is short-term trading, for hedging and speculating. Because most traders concentrate on these limited markets, there’s very little attention focused on longer-term options of individual companies. A lot of institutional investors just can’t invest in this sector, because their investment mandates won’t allow it and hedge funds are only interested in the short-term use of options to hedge positions. The great thing is you can find some options with significant mispricing across the entire market. A couple of weeks ago, I found options on a company with a $100 million market cap! So, there are definitely opportunities out there to take advantage of with these derivatives, but structural reasons prevent many investors from making the most of the opportunities available to them. There’s also a general lack of interest in this area. If you find a security that is undervalued and has a margin of safety, generally speaking there will be an even bigger mispricing in the options. To profit from this, you can sell put spreads or buy call spreads – the former eliminates the tail risk. If you feel comfortable just selling naked puts that will help you generate even more float, but you have to be comfortable buying the stock at the set price if it comes to it RH: One of the key caveats of value investing is minimising risk. Options trading is known for its high level of risk… CA: I think options trading is perceived as higher risk but it all comes down to the underlying stock. I think the real risk stems from a lack of knowledge about option pricing and stock valuation. As we know, a stock price will fluctuate much more than the underlying business. This stock volatility leads to some extreme volatility in options pricing, which translates into more opportunities for the options investor. If you are buying into a higher quality business, this is a great way for greater returns and a higher margin of safety. The high quality nature of the business helps mitigate risk. Call spreads and put spreads also help mitigate risk as well. RH: Do you buy the underlying equity as well or do you just concentrate on the options? CA: I have an equity portfolio, but each situation really depends on several factors. This is more of an art than a science. Sometimes it depends on the liquidity of the options or the stock, and other times it depends how expensive the options are. For instance, if I have say 14 equity positions in my portfolio already, I might just buy the option to add to my options book rather than the stock. It really depends. Another example I can give is if I’ve owned a stock for a while, and the options suddenly become really expensive, then there’s a situation where I might be inclined to add on the options side. RH: What’s your investment time frame? CA: Generally, I invest on a one to two-year time frame with regard to options since those are the longest term options widely available on the market. The reason why I’ve chosen this time frame is because those are the options that are generally the most mispriced. If I could get options longer than that I would, sometimes I can get options for two-and-a-half years. Options are priced more or less on a bell curve with some skew around the current stock price. They are not valuation based, which leads to tremendous opportunities. For instance, volatility, which is one of the primary factors in options pricing, is extrapolated for the term of the option. This leads to increased mispricing for options as the option term increases. For example, back in January and February, the market was extremely volatile and options were pricing this elevated volatility to last continuously for the next couple of years, which gave me the opportunity to sell options on strong, competitively advantaged companies at exceptionally high prices. RH: Could you guide us through your investment process? CA: Sure, let’s say a stock is trading at $100 and under my valuation, I believe it’s worth $130 to $150. If I can sell puts at $85 and collect $8 in premium, a premium that expires in one year, to me that would be very attractive. In this scenario, my net buy price, if I were forced to buy, would be $77, otherwise, the options will expire and I get to keep the float. In this specific case, assuming I’m buying this competitively advantaged company at a 40-60% discount, I would be okay selling the puts outright and not put spreads because I would be happy to own the stock at $77. By looking at it this way, time becomes your friend because every day that goes by, the options are worth less, even if the stock doesn’t move. RH: Do you keep a lot of cash on hand to implement this strategy? CA: Yes, I typically keep around 15% to 20% cash, in case of negative surprises, but it generally depends on the underlying environment. If the implied volatility has come down quite a bit and there’s nothing attractive out there, I tend to stay away. I need to make it clear that valuation of the underlying business is not enough for me to be buying or selling options. The risk/reward is clearly more favourable when implied volatility is higher. RH: You’re not selling right now? CA: No, I’m not selling right now because the payoffs available are not significant enough. I forget the statistics but the VIX has collapsed by something like 50% to 60% over the past month and we are at levels we were at pre-August last year. I’ve actually been buying a little bit of tail risk insurance one year out as it’s fairly cheap here. So you need to work with what the market is giving you. Click to enlarge RH: Could you give us an example of something you are looking at or have looked at in the past? CA: Sure, one of the most attractive options plays in the recent past has been Apple (NASDAQ: AAPL ) in my opinion. This is a company that I’ve gotten to know well over the years and when the stock got down into the $90s, it was trading at a mid-teens free cash flow yield. The market was pricing in a massive decline in iPhone sales and profitability, which I felt was a fairly low probability event in the immediate future. Every couple of years, it seems Mr. Market reflects this paranoia in the stock. At that level, you could sell puts at a strike price of $90 and collect $15 to $16 in premium, for options expiring in two years. And if you wanted to be more conservative, you could’ve bought some further out of the money puts, take a really nice spread on that, collect the premium and have a really nice float for a year. That was probably one of the best risk/reward and liquid opportunities I’ve seen in a while. RH: When you’re looking at plays like this, do you tend to stick to defensive sectors or branch out into the more cyclical sectors, which may offer a greater return but a higher level of risk? CA: I tend to stick with defensives because with cyclicals, the volatility can be quite aggressive and you can really get hurt there. But I would be inclined to buy cyclicals if they were cheap enough and they had a competitive advantage over peers. Although if I did go down that route, I would buy long-term LEAPs to cap my downside, while leaving me exposed to a long-term cyclical recovery. My priority is limiting my losses, so I tend to get to know a few competitively advantaged businesses very well, and then when the market throws up the opportunity, look at the stocks and the options and pick the securities that give you the best risk reward. There isn’t really much to add to the process in terms of investing, the options just give you another avenue with which to profit from the underlying investment, another tool in the kit so to speak. I think by selectively writing options, at times when the market is offering the best risk reward ratio, over the long term, the strategy should generate significant returns. RH: I think one of the factors that would scare most investors away from using this strategy, are the potential drawdowns that are generally associated with using options, rather than the traditional buy-and-forget style of value investors. CA: Well, first and foremost I’m a value investor. If I find a competitively advantaged business that I like, I’m more than happy to hold forever. When it comes to the drawdowns, that is a problem, but it’s a problem that can be mitigated through strategies like using put and call spreads as well as buying tail risk insurance. Sure, the performance may be a little bumpier than most investors are used to, but I think that if you’re disciplined with your underwriting, it will work out very well over time. I think psychology is important here. Mark-to-market returns, like we saw in January and February of this year can be very violent. Although, at the same time plenty of new opportunities arise, so any new insurance you’re writing will be very profitable. There is also position sizing to consider, you need to make sure your options portfolio won’t drag you down. If you’re doing cyclical recovery stories, turnarounds, reversion to the mean plays, I don’t think this strategy will work as well. You just don’t have the margin of safety that you need in my opinion. Whereas if you’re talking about companies like Apple or Berkshire Hathaway, that have strong balance sheets and competitive advantages, then you have something that you can base your value and a platform from which to base your option strategy on – you can clearly identify the price and value of the company along with the current call or put premiums to quantify potential returns. Most of the businesses I own right now have net cash balance sheets and double-digit free cash flow yields. Actually, believe it or not, when you write options on these sort of companies, there isn’t much of a market. And that’s where the opportunity is because not many people play in this sandbox. RH: Options aren’t something we cover much here at ValueWalk, and there’s a good chance that some readers will never have used options before. So, could you just give those readers a brief rundown of options investing and how they should approach the market? CA: That’s a good question, I think one of the things that puts people off this market and trips them up is approaching the options market as a purely speculative market, without considering the underlying stock they are buying. One thing I will never understand is how so many traders use options but have no idea about the underlying valuation of the security. That’s the equivalent of buying or selling insurance without knowing what your collateral is! I think if investors want to get into this, they need to understand properly how options work, either by taking a class or reading up on the subject – Buffett himself has been a major user of options and derivatives but this doesn’t get as much attention. There’s so much misinformation out there and people really need to understand how the market works and how to apply that to their own trading strategy, as well as understanding what the actual upside and downside is. A lot of people I’ve spoken to about it will say, “I’ve tried options and I’ve lost all my money” but what they don’t realise is, if you put $1,000 down, you can lose the entire $1,000. It’s even more important when you’re selling naked puts or calls, because you have unlimited downside. To the uninitiated, one of the best and free ways to learn in my opinion is to look at how Buffett has written about the options market in his previous annual letters and then try and understand how Black-Scholes options pricing works, and how it doesn’t work. I started as a value investor, and then through learning about options pricing adapted my strategy to suit me and my investment background. I’m afraid to say there’s no perfect answer to this, you just need to learn as much about the subject as possible and develop your own strategy. RH: So your advice would be to find the stock, calculate the value, buy as a value investment and then look at the options? CA: Exactly. Since your “collateral” is the underlying business, you need to gain a firm foundation in fundamental research to understand what it is worth. Once you have established a valuation range and a margin of safety, you have more flexibility in understanding which options to use. To me, it’s easier if you understand the valuation first and then the derivatives. It’s a much simpler and straightforward approach. RH: Chris, that’s great. Thank you for your time today. CA: You’re welcome. Thank you for the interview. Disclosure: Past performance is not indicative of future returns. This information should not be used as a general guide to investing or as a source of any specific investment recommendations, and makes no implied or expressed recommendations concerning the manner in which an account should or would be handled, as appropriate investment strategies depend upon specific investment guidelines and objectives. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. This document contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. The views expressed here are the current opinions of the author and not necessarily those of ValueWalk. The author’s opinions are subject to change without notice. There is no guarantee that the views and opinions expressed in this document will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. No representations, expressed or implied, are made as to the accuracy or completeness of such statements, estimates or projections, or with respect to any other materials herein. Under no circumstances does the information contained within represent a recommendation to buy, hold or sell any security, and it should not be assumed that the securities transactions or holdings discussed were or will prove to be profitable. No part of this material may be copied, photocopied, or duplicated in any form, by any means, or redistributed without ValueWalk’s prior written consent.

Get Off The Roller Coaster With Vanguard Total Stock Market ETF

Roller coaster start for investors in 2016 This year, evidence of stress came early as the market dropped like a brick before swinging back up like a rocket. Rampant, wrenching, volatility is maddening for many investors who see no choice but equities for financial gains in the current low interest rate savings environment. Picking individual stocks is risky in a traders’ marketplace. For the long-term investor, a maximally diversified ETF may reduce stress helping to weather short-term shocks like those that were seen last January while offering modest gains across a 5 to 10 year time horizon and greater peace of mind. Volatility and Downside Risk Recent Fed commentary and behavior can only confuse the Markets, and that spells continued and perhaps even greater volatility . The contradictory nature between the ” Fed speak” of the Chair, Janet Yellen, and other members of the FOMC has sent mixed messages about removing unprecedented accommodation from U.S financial markets. Yellen’s dovish response to maintain low interest rates in the U.S. signals a fear of declining global economic growth. The picture concerning the future direction of interest rates is clouded and that presages the possibility of a continued roller coaster stock market ride. At Fortune’s Global Forum, JPMorgan (NYSE: JPM ) CEO, Jamie Dimon, hinted at expected greater volatility stating that, “markets will be scary until a normal interest rate environment returns.” This view is mirrored in the recent low interest rate of the 10 year U.S. Treasury Bill which has fallen to 1.77% as scared money retreats from the markets. For some savvy traders, volatility may translate into higher short-term returns, but this isn’t always the case because the psychology of greed, and more importantly, in my experience, of fear, can reverse markets on a dime. This can result in devastating losses for some market segments as well as individual stocks. On the other hand, the average investor, by nature, tends to be a long-term animal, and that means having to contend with both volatile whiplash swings as well as the fear of downside market risks. It has always been a maxim for me to take both volatility and downside risk into consideration when I am in investment mode. I have also come to believe that volatility does not always translate into higher returns. Diversification is a great tool for dealing with both volatility and downside risk. Vanguard Total Stock Market ETF The Vanguard Total Stock Market (NYSEARCA: VTI ) ETF is a significantly diversified proven winner. It seeks to track the performance of a benchmark CRSP U.S. Total Market Index. The investment approach is focused on: Large-, mid-, and small-cap equities diversified across growth and value styles. A passively managed, index sampling strategy. Maintaining a fully invested fund utilizing low expenses to minimize net tracking errors. Accurately representing the U.S. equity market while delivering low turnover. Key Fund Facts Clearly, a key fact for investors to consider is the expense ratio for purchasing the ETF. As of 04/28/2015 it is 0.05% and compares very favorably with the Lipper peer average expense ratio of 1.17% as of 12/31/2005. Total net assets are $389.8 billion as of 02/29/2016. Outstanding shares are 560,322,004 as of 03/31/2016. The risk and volatility Beta based on the 5 year Primary benchmark and the Broad-based benchmark is 1.00. Sector Weightings Courtesy of the Author As noted in the chart above, at present the heaviest sector weightings are in Financials, Technology and Consumer goods while the lowest are in Basic materials, Telecommunications and Utilities. Comparative Performance Courtesy of the Author Of the 13 funds listed in the table above, VTI leads the group with a ten year average return of 6.13% while maintaining a maximum level of diversification. The 3 and 5 year returns are 8.21% and 8.63%, respectively. Short-Term Performance The fund’s overview is described by the table below. It is highly capitalized and provides a 2.2% dividend yield as well as capital gains. Click to enlarge Courtesy of the Author Although VTI shows a loss for the first three months of this year and an -8.2% one-year return, it sports a 10% total market return for the last three years during a period of exceptional market volatility. Cumulative Long-Term Performance Click to enlarge Courtesy of the Author Long-term cumulative performance over 10 years is 97.52% with a cumulative performance of 133.12% since inception on 05/24/2001. VTI 5 Year Chart A 5 year weekly stock price chart shows strong performance. Extrapolating data from the chart shows a low close of 51.04 on October 3, 2011 and a close on April 4, 2016 of 105.04 for a share value gain of 51%. This corresponds to an approximate 5 year annual gain of 8.3% seen in the Betterment Comparative Performance chart provided above. Click to enlarge C ourtesy of the Author VTI Bounce-Back As Market Recovered Courtesy of the Author VTI showed a strong bounce-back in mid-February of 2016 following the volatile 10% market decline that took place during January 2016. Additional data supporting VTI which is also available as a mutual fund can be reviewed on the Vanguard site . Where Should We Be In The Market? Nobody can call the market; we can only consider economic variables and try to place ourselves in the best situation to profit from our investments, and most importantly, to avoid significant financial loss. We can also learn from past experience if we are in a position where we are personally vulnerable to the stressful impact of severe market swings. I am not sanguine in my near-term expectations that stock markets can continue to rise in the current cycle . I make no predictions, but point out the following for your consideration: U.S. Market Indices are nearing highs in a climate of weak global economic conditions. But, I cannot know what will happen in the longer term and therefore the choice of selling my portfolio and exiting the stock market is a poor choice in my opinion. I consider the U.S dollar to be the strongest currency and the U.S. economy to have the greatest potential to generate wealth given better economic policies. The question for all investors now is, where do you feel the most comfortable putting your money? Conclusion Remaining invested for the near term, in my opinion, requires the broadest diversification in the strongest companies, and I consider the U.S. the best place to be at this time. The Vanguard Total U.S. Market ETF may be a place for some investors to seek refuge. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VTI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: The information and data that comprise the content of this article came from external sources that I consider reliable, but they have not been independently verified for accuracy. Although I reserve the right to express points of view, they are my reasoned opinions, and not investment advise. I am not responsible for investment decisions you make. Thank you for reading and commenting.